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Understanding the President’s new budget proposal

I have been keeping my recent posts fairly short. This one is instead more of a reference post, and it is not for the faint of heart. I hope it is useful, I know it is long. Consider yourself warned.

Today the President proposed:

a negotiating process;

deficit and debt targets;

a new budget process trigger mechanism;

and new spending cuts in Medicare, Medicaid, other entitlements, and defense.

Compared to the budget he proposed in February, he offers no new proposals in non-security discretionary spending (I think), taxes, or Social Security.

Process

The President proposes a 16-person bicameral bipartisan Congressional budget negotiation, led by VP Biden, beginning in early May. Each Congressional leader (Boehner, Pelosi, Reid and McConnell) would name four Members. The group’s goal would be “to agree on a legislative framework for comprehensive deficit reduction.”

The President’s timeframe could foul up the normal budget calendar. This is a consequence of him waiting to go second.

Deficit & debt targets

The President proposes a budget deficit “of about 2.5% in 2015” and that is “on a declining path toward close to 2.0% toward the end of the decade.” (That second test is a mess.) Compared to what he argues he proposed in February (using OMB scoring), that’s only 0.7 percentage points lower in 2015 and only 1 percentage point lower in 2021.

He proposes that debt/GDP be “on a declining path … by the second half of the decade.”

Budget credibility: Quite low, for three reasons.

Several of the largest specific proposals described below have very low credibility (they’re almost gimmicks).

All proposals of this nature phase in their changes over time, but these proposals push that farther than most. The later the pain begins, the more time there is for Congress to undo it. The President’s proposal backloads the savings so much that they talk about a 12-year window rather than the traditional 10 years. That’s a sign of a weak proposal.

OMB says the President’s February budget reduces the 2021 deficit to 3.1% of GDP. CBO said the same policies would result in a 4.9% deficit in that year. That’s a big gap, and the same will likely be true here. CBO is likely to say that the President’s specific policies don’t come close to hitting his stated deficit targets. If they’re right, the trigger would not be a failsafe and would kick in with big tax increases.

Taxes

While the President reiterates two big tax proposals from his February budget, he does not propose explicit new tax increases.

Despite having signed a law last December that prevented income, capital gains, or dividend tax increases for all Americans, the President stresses that next time he will insist that tax rates on “the rich” should go up. Next time begins in 2013. Small business owners, this means you.

He also reiterates his proposal to limit itemized deductions for high-income taxpayers. The lion’s share of revenue loss from individual tax expenditures comes from broad-based and wildly popular preferences: the deductibility or exclusion of home mortgage interest, of retirement plan contributions, of charitable contributions, of state and local income and property taxes, of employer-provided health insurance, and of capital gains. The last two times he proposed this he had almost zero Congressional support, including from his own party.

While he is not proposing new explicit tax increases beyond those he proposed in February, his new trigger proposal would likely result in big tax increases.

The Trigger (“Failsafe”)

The President proposes a new debt trigger, similar to policies in place a couple of decades ago. (The most well known is called “Gramm-Rudman-Hollings.”) The trigger is new and important.

The President’s proposal is structured as an if … then … proposition.

If, by 2014, the debt/GDP ratio is not (stabilized and projected to decline by the end of the decade)

… then certain mandatory spending programs are cut across-the-board, and certain taxes are increased, by enough to ensure the debt meets the “if” test.

It’s unprecedented (but not crazy) to structure this as a debt test rather than a deficit test. As a rule of thumb, a deficit of 3% of GDP roughly keeps debt/GDP stable, so the President’s test is roughly equivalent to:

If, by 2014, the deficit/GDP is not 3%, and below 3% by the end of the decade…

The President’s team thinks that his specific policy proposals would reduce the deficit enough that the trigger would never kick in. He therefore calls it a “failsafe.” In past years the term “backstop” has been used for similar triggers. Under this logic the trigger is not used to force cuts, it’s used to ensure them.

If, however, the President’s scoring is wrong and too optimistic, or if the trigger becomes law but the specific policy changes don’t, then this proposal serves a new purpose: it would be a mechanism that automatically changes policy unless Congress acts to stop it. That’s a big distinction. As a general rule, a backstop trigger has a much better chance of being sustainably implemented than an action-forcing trigger.

Trigger proposals like this pop up every few years. Two big questions about any such proposal are:

What happens if the trigger kicks in?

How does this affect Congress’ incentive to legislate?

What happens if the trigger kicks in?

The President’s proposal is similar to past triggers in that it exempts all discretionary spending, Social Security, and interest on the debt. While past triggers limited the amounts that Medicare and Medicaid could be cut, the President’s trigger appears to exempt them entirely. The White House fact sheet says the trigger “should not apply to Social Security, low-income programs, or Medicare benefits.” Elsewhere it says the trigger applies only to mandatory spending.

Assuming that “low-income programs” includes Medicaid, this means the trigger appears to apply to at most about $300 B (if triggered this year) in “other mandatory” spending. Half of that would hit federal retiree payments, a quarter would hit veterans’ benefits (if not defined as “low income”), and the rest would hit smaller things like farm subsidies.

It therefore appears that the President’s trigger would exempt more than 90% of government spending from the automatic across-the-board cut.

The trigger would also raise taxes by implementing “across-the-board spending reductions …

[in] spending through the tax code.” In other words, the trigger would somehow (how??) automatically reduce tax expenditures across-the-board (rather than raising rates, it appears). No past trigger has included a tax increase. This is new.

The fog lifts. The across-the-board trigger would apply to less than 10% of federal spending and would also raise taxes. And since it would apply only to itemized deductions, it’s only going to hit a portion of those paying income taxes, which is only a portion of all Americans.

The trigger is, in effect, a tax increase trigger on those who itemize deductions, with a little other mandatory spending thrown in for good measure.

The overwhelming impact of the trigger would be to raise taxes on those who itemize. A much smaller portion of triggered deficit reduction would come from automatic spending cuts.

When you combine the automatic nature of this policy with the absence of specific policies needed to sufficiently reduce spending in the long run, the effect of this trigger would be to shift the burden of future entitlement spending increases away from deficits and onto higher income taxpayers. The future default would be that entitlement spending would grow at an unsustainable rate, and taxes on “the rich” would grow to hold deficits below 3% of GDP.

How does this affect Congress’ incentive to legislate?

Since the overwhelming burden of the trigger would be through tax increases, it would significantly advantage the Left in future fiscal policy battles. Big spenders/taxers would know that, if no future legislation were enacted, automatic tax increases would kick in. They would therefore be better able to walk away from what they think is a bad deal. This is incredibly dangerous if your goal, like mine, is to cut government spending.

Spending

The President proposes specific changes (“cuts”) to Medicare and Medicaid, but it’s questionable how real most of them are. He sets numeric goals for additional savings in discretionary spending, both for defense and nondefense, as well as for “other mandatory” programs, but he does not offer specific spending cut proposals in any of these areas. In some cases that’s legit, in others it’s not.

He once again punts on the largest component of federal spending, Social Security ($727 B this year).

Medicare

The President proposes incremental changes to Medicare that would slow its growth in the short run. These changes focus on cuts to provider payment rates. Doctors, hospitals, and other providers of medical goods and services would receive fewer dollars per service.

The easiest way to think about government Medicare spending is that it’s the product of three factors: the number of people eligible for benefits, times the amount of services each person receives, times the government payment per service. The President focuses entirely on the third factor: government dollars per service. The President contrasts his approach to Paul Ryan’s, in that Ryan tries to get at all three factors. More on this in a later post.

The President singles out drug manufacturers as a specific target for budgetary savings, and otherwise relies almost entirely on the so-called IPAB (Independent Payment Advisory Board) that was created by the health care laws last year. The IPAB is a bunch of appointed officials who, under current law, have authority to recommend changes in Medicare provider payment rates. The President would dial up the budget savings target for the IPAB and give them the authority to force those changes if Congress did not act. A Democratic majority Congress last year rejected giving IPAB this forcing authority, and Congressional Republicans hate it even more.

Giving the IPAB forcing authority is a Medicare parallel to the President’s tax trigger. He thus has a trigger backed up by a trigger.

Budget credibility: The drug savings proposals are real. The IPAB savings are at best highly questionable. The President gets the overwhelming majority of his proposed savings from the latter. Since Medicare savings are the largest component of the President’s proposed new spending “cuts,” reliance on the untested IPAB as a backdoor procedural mechanism is a key budgetary weakness in the President’s plan.

Medicaid & Children’s Health Insurance

The President proposes establishing a consistent federal “match rate” across Medicaid and the Children’s Health Insurance Program (CHIP). Both are shared federal-state programs, in which the Feds pay a portion of each dollar spent and the State pays the rest. Each State has a different federal “match rate,” and these match rates vary within and across programs for different types of services. This is potentially a good reform, but it’s not clear whether the overall effect would be to increase or cut overall federal spending on these programs. That is super important.

He dings Medicaid reimbursement for drugs, but his big Medicaid savings will come from cracking down on States’ attempts to gimmick their accounting to draw down more federal matching dollars for each State dollar spent. While I want to wait for the specifics, as a general matter this is very good policy, especially for federal taxpayers. Governors will hate it and push back hard, because several of them use these gimmicks to solve their State budget problems.

He’s also got some “reforms” to address high-cost beneficiaries and users of prescription drugs.

Budget credibility: The match rate, drug reimbursement provisions, and State gimmick provisions are real and would save money. I am skeptical that the high-cost beneficiary/drug provisions would actually reduce spending by any significant amount.

Other mandatory spending programs

“Other mandatory spending” excludes the Big 3 entitlements: Social Security, Medicare, and Medicaid. For comparison, in FY2011 those three programs combined will spend $1,493 B, while all other mandatory programs combined will spend $615 B. So while other mandatory is a whole lot of money, it’s small relative to the Big 3. And the Big 3 are the source of future spending growth, not other mandatory.

Under current law the biggest components of other mandatory spending are the low-income support programs (aka “welfare”, $280 B this year combined): cash welfare, food stamps, earned income tax credits, etc. Federal employees’ retirement is big ($146 B this year), and this year unemployment insurance payments are huge ($129 B). Other big chunks are veterans’ benefits ($78 B) and agriculture subsidies ($16 B).

The President provides a savings target for the other mandatory category but offers no specifics, other than to say proposals from the Bowles-Simpson Commission “and other bipartisan efforts … should be considered.”

Budget credibility: Zero. Without specifics, or at least per program targets (e.g., $X B from farm subsidies, $Y B from federal retirees), this is just pulling numbers out of thin air.

Discretionary spending

He is proposing additional cuts to defense and security discretionary spending. Details are TBD.

On the non-security side it appears he simply takes the new appropriations deal and extends it for ten years. But while he claims $200 B in non-security discretionary savings over 10 years in addition to the $400 B in savings from the President’s budget, it appears that he is relabeling what has already been decided in the recent appropriations deal.

As a policy matter this is smaller and therefore less important than the other changes listed above, but it’s a political flashpoint. Reporters should ask the Administration and CBO how the President’s new non-security discretionary spending proposal compares to a straight extension of the new FY11 appropriations soon-to-be-law. It’s even possible that he is proposing to increase spending and, in effect, “undo” some of this year’s deal in future years. We can’t tell until we see this comparison.

Budget credibility: Since discretionary spending totals can be enforced by spending caps that have a long history of enforceability, credibility here is fairly high. Unlike for “other mandatory” spending, you don’t really need to propose specifics to establish a credible and enforceable path for future discretionary spending. At the same time, you should be very skeptical of the presentation of the claimed non-security “savings.” This appears to be a misleading presentation. It looks like they are cutting only defense/security discretionary.

Analysis

Here are four broad reactions to the new proposal.

First, this is a short-term budget, not a long-term budget. There are three forces driving our long-run government spending and deficit problem:

demographics;

unsustainable growth in per capita health spending; and

unsustainable promises made by past elected officials, enshrined in entitlement benefit formulas.

The President’s proposal addresses none of these forces. It instead spends most of its effort on everything but those factors. His proposed Medicare and Medicaid savings, while large in aggregate dollars, are quite small relative to the total amount to be spent on those programs, and he lets the largest program in the federal budget (Social Security) grow unchecked. While Bowles and Simpson focused their efforts on the major entitlements and also addressed other spending areas and taxes, the President’s proposal does the reverse, focusing on other mandatory spending, taxes, and defense. That’s a short-term focus.

Second, this proposal “feels” to me like the recently concluded discretionary spending deal. It’s the size of a typical deficit reduction bill that Congress usually does every five or so years. I’m sure the affected interest groups are even now preparing to invade Washington to explain how a 3-5% cut will devastate them. The problem is that our fiscal problems are now so big that they require much larger policy changes.

Third, while framed as a centrist proposal, the substance leans pretty far left. It’s deficit reduction through (triggered) tax increases on the rich, plus defense cuts, plus unspecified other mandatory cuts and process mechanisms that might cut Medicare provider payments. Centrist Democrat proposals do all of these things, but they also reform Social Security and Medicare, usually through a combination of raising the eligibility age, means-testing, and raising taxes.

Fourth, the President’s speech was campaign-like in its characterization of and attacks on the Ryan plan.

The President’s proposal could be the opening bid in a negotiation with Congressional Republicans. When you combine this substance with the President’s aggressive partisan attacks and framing of the Ryan budget, however, it’s hard to see how this leads to a big fiscal deal this year or next. A small incremental bill, which “cuts” spending by a couple hundred billion dollars over the next decade, is possible. But the chances of a long-term grand bargain in the next two years just plummeted from an already low starting point.